1. Market Risk

2. Introduction Market risk management is no longer the domain of big investment banks. It is becoming a buzz phrase across all areas of business, from smaller banks and hedge funds to insurance companies, pension funds, asset managers and non-financial companies. The advances in market risk management are part of a much broader trend in financial markets and institutions: the recognition that return is only one side of the performance. Information about risk, including relatively unlikely or unexpected risks, is necessary for evaluating trading strategies, investment choices and asset allocation.

3. Definition of market risk -Market risk is the risk that the value of an investment will decrease due to moves in market factors. -Market risk is exposure to the uncertain market value of a portfolio. A trader holds a portfolio of commodity forwards. he knows what its market value is today, but he is uncertain as to its market value a week from today. She faces market risk.

4. Definition of market risk The risk of losses in on and off-balance-sheet positions arising from movements in market prices. The day-to-day potential for an investor to experience losses from fluctuations in securities prices. This risk cannot be diversified away. Also referred to as "systematic risk". The beta of a stock is a measure of how much market risk a stock faces.

5. Standard market risk factors Equity risk, or the risk that stock prices will change. Interest rate risk, or the risk that interest rates will change. Currency risk, or the risk that foreign exchange rates will change. Commodity risk, or the risk that commodity prices (i.e. grains, metals, etc.) will change. Sometimes, a fifth risk factor is also considered: Equity index risk, or the risk that stock or other index prices will change.

6. Equity risk Equity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it.

7. Interest Rate Risk Interest rate risk is the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured by the bond's duration

8. Currency risk risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.

9. Currency risk For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would realize no gain.

10. Commodity risk Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas و electricity etc. A Commodity enterprise needs to deal with the following kinds of risks: Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices) Quantity risk Cost risk (Input price risk( Political risk

11. Commodity risk Groups at Risk There are broadly four categories of agents who face the commodities risk Producers) farmers, plantation companies, and mining companies) face price risk, cost risk (on the prices of their inputs) and quantity risk Buyers (cooperatives, commercial traders and trait ants) face price risk between the time of up-country purchase buying and sale, typically at the port, to an exporter.

12. Commodity risk Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion. Governments face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise (generally the case with metals and energy exports) or if support or other payments depend on the level of commodity prices.

13. Measuring market risk Market risk is typically measured using a Value at Risk methodology. Market risk can also be contrasted with Specific risk, which measures the risk of a decrease in ones investment due to a change in a specific industry or sector, as opposed to a market-wide move.

14. Market Risk management All businesses take risks based on the two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. The same principles apply to market risk and, while smaller businesses may have a less formal approach to analyzing the risks, larger businesses tend to use sophisticated software packages to help determine the best course of action.

15. Market Risk management Market risk is managed with a short-term focus. Long-term losses are avoided by avoiding losses from one day to the next. On a tactical level, traders and portfolio managers employ a variety of risk metrics duration and convexity, the Greeks, beta, etc. — to assess their exposures. These allow them to identify and reduce any exposures they might consider excessive. On a more strategic level, organizations manage market risk by applying risk limits to traders' or portfolio managers' activities. Increasingly, value-at-risk is being used to define and monitor

16. Managing Market Risk by Forward Pricing Forward pricing strategies can minimize the impact of market price variation. Strategies for making a profit: -cost of production lower than industry average. -prevent selling prices below cost of production. - sell significant annual production above cost of production.

17. Business risk Business risk is exposure to uncertainty in economic value that cannot be marked-to- market. Business risk is managed with a long-term focus. Techniques include the careful development of business plans and appropriate management oversight. book- value accounting is generally used, so the issue of day-to-day performance is not material. The focus is on achieving a good return on investment over an extended horizon.

18. Market risk versus business risk The distinction between market risk and business risk is ambiguous because there is a vast "gray zone" between the two. The distinction between market risk and business risk parallels the distinction between market-value accounting and book-value accounting.

19. Example Suppose X firm electricity wholesaler is long a forward contract for on-peak electricity delivered over the next 3 months. There is an active forward market for such electricity, so the contract can be marked to market daily. Daily profits and losses on the contract reflect market risk.

20. Example Suppose the firm also owns a power plant with an expected useful life of 30 years. Power plants change hands infrequently, and electricity forward curves don ’ t exist out to 30 years. The plant cannot be marked to market on a regular basis. In the absence of market values, market risk is not a meaningful notion. Uncertainty in the economic value of the power plant represents business risk.

21. Questions Questions and answers What is the market risk in finance situations? -It's the portion of the total risk attributable to volatility of the market.

22. Questions and answers What is market risk premium? Or what is the implication behind it? What does it represent?What is market risk premium? Or what is the implication behind it? What does it represent? -The market risk premium is most commonly viewed as the expected return one would get for investing in the stock market versus the "risk-free" rate (government bonds). So if government bonds yield 5%, and people expect the stock market to return 8% over a long period of time, then the market risk premium is 3%. Academics often estimate the actual market risk premium to be 3-5%.